University of the Witwatersrand, Johannesburg School of Accountancy Base Erosion and Profit Shifting in South Africa: A critical analysis of the effectiveness of the transfer pricing rules with regard to the elimination of profit shifting. Xolani Mpanza A research report submitted to the Faculty of Commerce, Law and Management, University of Witwatersrand, Johannesburg, in partial fulfilment of the requirements for the degree of Master of Commerce (specialising in Taxation). Johannesburg 2017
Transcript
University of the Witwatersrand, Johannesburg
School of Accountancy
Base Erosion and Profit Shifting in South Africa: A critical
analysis of the effectiveness of the transfer pricing rules
with regard to the elimination of profit shifting.
Xolani Mpanza
A research report submitted to the Faculty of Commerce, Law and Management,
University of Witwatersrand, Johannesburg, in partial fulfilment of the requirements for
the degree of Master of Commerce (specialising in Taxation).
Johannesburg 2017
DECLARATION
I declare that this research is my own unaided work. It is submitted for the degree of
Masters in Commerce in the University of Witwatersrand, Johannesburg. It has not
been submitted before for any other degree or examination at any other university.
~----
Xolani Mpanza
17 April 2017
2
ACKNOWLEDGEMENTS
I would like to extend my sincere appreciation to the following:
My Lord and my saviour for His enduring love and grace, I wouldn't have been able to complete this task if it wasn't for His mercy. He deserves the glory.
My wife and my son for their encouragement and support, your inspiration gave me strength to complete this research. Thank you for believing in me
My mother and my siblings for their support and interest in my studies, I really appreciate your unwavering support.
My study leader, Roy Blumenthal, for his guidance and support throughout the duration of the research.
3
ABSTRACT
Tax base erosion and profit shifting (BEPS) is a key tax issue both locally and
internationally. Multinational corporations are constantly trying to find means of
reducing the amount of taxation that is payable by identifying gaps in tax laws. The
aim is to lower the taxation that the group would be liable for. This study will analyse
the developments of tax base erosion and profit shifting. There will also be an
examination and comparison of South African transfer pricing laws with other
countries' tax laws (United State of America, United Kingdom, Australia and Nigeria),
specifically with regards to discouraging profit shifting in order not to obtain a tax
advantage. Section 31 of the Income Tax Act 58 of 1962, is one of the tools that is
currently being utilised by South Africa in addressing the issue of profit shifting. An
analysis of Section 31 will be undertaken and it will be necessary to consider whether
there are any loopholes or vagueness in the tax laws that may result in taxpayers
manipulating the interpretation of the law in order to obtain a tax advantage. Profit
shifting is a global problem that has left many countries deliberating on what could be
an ideal solution. This study will also propose recommendations that might be used by
Commissioner for the South African Revenue Service.
Key Words: tax base erosion, profit shifting, impermissible tax avoidance,
Organisation for Economic Co-operation and Development, aggressive tax planning,
transfer pricing, tax gap, tax avoidance, scheme, abnormalities, advanced pricing
agreement, commercial substance, base erosion and profit shifting,
4
LIST OF ACRONYMS
APA Advanced pricinq aqreement BEPS Base erosion and profit shiftinq CFC Controlled Foreiqn Company DTC Davis Tax Committee HMRC Her Majesty's Revenue and Customs IRS Internal Revenue Service, USA SAAS South African Revenue Sevice TP Transfer Pricing MAP Mutual agreement procedure MNEs Multinational enterprises OECD Organisation for Economic Co-operation
and Development, PE Permanent Establishment USA United State of America UK United Kinqdom
5
TABLE OF CONTENTS
DECLARATION
ACKNOWLDEGMENT
PROPOSED ABSTRACT
LIST OF ACRONYMS
CHAPTER 1 Introduction
1.1 Background
1 .2 Problem statement
1 .3 Sub-problems
1.4 Purpose statement
1 .5 Research and design methods
1.6 Brief oveNiew of chapters
CHAPTER 2 Analysis of Section 31
2.1 Introduction
2.2 The concept of transfer pricing
2.3 The old transfer pricing rules
2.4 The new transfer pricing rules
CHAPTER 3 Risk posed by base erosion and profit shifting
3.1 Introduction
3.2 The economic impact of BEPS
3.3 Tax havens' impact on the spread of BEPS
3.4 Impact of strict tax laws on investment
CHAPTER 4 Lack of commercial substance
4.1 Introduction
6
2
3
4
5
9
9
11
12
13
14
15
17
17
17
18
20
22
22
23
26
28
4.2 Simulating transactions to achieve BEPS
4.3 Advance Pricing Agreement
4.3.1 Advantages of APAs
4.3.2 Disadvantages of APAs
28
29
30
32
CHAPTER 5 Necessary actions to be taken to address base erosion and profit shifting
5.1 Introduction 33
5.2 Modification of transfer pricing rules 33
5.3 Comparison of South Africa's transfer pricing rules with international standards 35
5.3.1 United States of America (USA) 35
5.3.1.1 Affected transactions 35
5.3.1 .2 Preferable benchmarking set 35
5.3.1 .3 Advanced pricing agreements 36
5.3.2 United Kingdom 37
5.3.2.1 Advance pricing agreements 37
5.3.2.2 Affected transactions 37
5.3.3 Australia 38
5.3.3.1 Affected transactions 38
5.3.3.2 Advance pricing agreements 38
5.4 Progress made by OECD 39
5.5 Court cases 43
5.5.1 DSG and (others) v HMRC 43
5.5.2 Altera Corp v Commissioner and Xilinx Inc v Commissioner 45
7
CHAPTER 6 Discussion and conclusion
6.1 Introduction
6.2 Outcome of the research
6.3 Recommendation
6.3 Areas requiring further research
Reference List
8
48
48
48
50
51
1.1 BACKGROUND
CHAPTER 1
INTRODUCTION
BEPS is a tax term used to describe international tax planning strategies that rely on
mismatches and gaps that exist between the tax rules of different jurisdictions, to
minimise multinational entities' tax that is payable by the group, by either making tax
profits 'disappear' or shifting profits to low tax jurisdictions where there is little or no
genuine activity. According to the Financial Times (n.d.):
BEPS strategies are not illegal; rather they take advantage of different tax rules operating in different jurisdictions, which may not be suited to the current global and digital business environment.
Profit shifting can be regarded as a tax avoidance scheme and in terms of the OECD
(n.d.), tax avoidance is an:
... arrangement of a taxpayer's affairs that is intended to reduce its ability and that although the arrangement could be strictly legal, it is usually in contradiction with the intent of the law it purports to follow.
It is important to note that tax avoidance is not tax evasion. Tax evasion is where a
taxpayer unlawfully arranges his affairs in such a way that he escapes any tax liability
which he ought to pay. Multinational entities that are involved in profit shifting activities
usually take advantage of the poorly written tax laws. In an increasingly
interconnected world, national tax laws have not kept pace with global corporations,
fluid capital, and the digital economy, leaving gaps that can be exploited by companies
who avoid taxation in their home countries by pushing activities (genuine or otherwise)
abroad to low or no tax jurisdictions. This undermines the fairness and integrity of the
tax systems.
According to the OECD's Action Plan report on base erosion and profit shifting, there
are 15 specific actions that are needed in order to equip governments with instruments
that would address the arrangements those results to double non-taxation. These 15
actions include:
• Address the tax challenges of the digital economy.
• Neutralise the effects of hybrid mismatch arrangements.
• Limit base erosion via interest deductions and other financial payments.
• Counter harmful tax practices more effectively, taking into account
transparency and substance.
• Prevent treaty abuse.
• Prevent the artificial avoidance of permanent establishment status.
• Develop rules to prevent BEPS by moving intangibles among group members.
• Develop rules to prevent BEPS by transferring risks among, or allocating
excessive capital to, group members.
• Develop rules to prevent BEPS by engaging in transactions which would not, or
would only very rarely, occur between third parties.
• Establish methodologies to collect and analyse data on BEPS and the actions
to address it.
• Require taxpayers to disclose aggressive tax planning arrangements, this
would be a case whenever a taxpayer actively push limits of what is allowed in
terms of the law e.g. this may be stretching the definition of a term in legislation
to access a loophole, or dressing up an arrangement so that it appears to be
something else (Beattie, 2015).
• Make dispute resolution mechanisms more effective.
• Analyse the tax and public international law issues related to the development
of a multilateral instrument.
• Re-examine transfer pricing documentation.
In terms of the OECD (n.d.), profit shifting reduces government revenue and it
contributes to the increase in the tax gap, therefore it is critical for governments to
prevent it at all costs. Some of the effects of profit shifting include a corrosive effect
upon taxpayer compliance, the uneconomic allocation of resources, upward pressure
on marginal tax rates, an unfair redistribution of the tax burden and a weakening of the
ability of Parliament and National Treasury to set and implement economic policy.
Transfer pricing rules play a critical role in ensuring that tax avoidance is reduced or
eradicated. According to the OECD (n.d.), 'transfer pricing is the price charged by a
company for goods, services or intangible property to a subsidiary or other related
10
company·. It results in the setting of prices among related entities. In terms of the
OECD (n.d.), ·Abusive transfer pricing occurs when income and expenses are
improperly allocated for the purpose of reducing taxable income·. For example, if a
subsidiary company sells goods to a parent company, the cost of those goods is the
transfer price. Legal entities considered under the control of a single corporation
include trusts and companies that are wholly or majority owned ultimately by the
parent corporation. Certain jurisdictions consider entities to be under common control
if they share family members on their boards of directors. Transfer price can be used
as a profit allocation method to attribute a multinational corporation's net profit (or
loss) before tax to other countries where it does business.
Appropriate clarification of transfer pricing laws by the South African government, will
make the implementation of transfer pricing laws easier and that might reduce non
compliance. In April 2012, an amendment to Section 31 of the Income Tax Act was
done in order to modernise South African transfer pricing rules and to bring it in line
with the latest transfer pricing guidelines issued by the OECD.
1.2 THE PROBLEM STATEMENT
There are a lot of uncertainties with regards to the practical application of transfer
pricing rules contained in Section 31 of the Income Tax Act.
The complexity of transfer pricing regulations and the continuously changing transfer pricing environment make it challenging for multinational companies to manage their transfer pricing position and to be compliant with the latest requirements (Wolf & Verhoosel 2014).
Non-compliance with the transfer pricing rules is increasing the tax gap and has
an impact on the economic stability of South Africa. There might still be a
substantial amount of uncertainty as to how SARS interprets and implements the
new transfer pricing rules. Of particular interest in this regard is how SARS intends
applying the arm's-length principle in the context of the thin capitalisation rules.
These uncertainties may create loopholes that weaken the fight against profit
shifting.
Section 31 is causing structural problems and uncertainty, as the literal wording unduly focuses on isolated transactions as opposed to arrangements driven by an overarching profit objective. In addition, SARS is of the opinion that the language gives rise to an excessive emphasis of the Comparable Uncontrolled Price (CUP) method as opposed to other more practical transfer pricing methodologies. Further, SARS is also of the opinion that the current legislative emphasis on "price" as opposed to "profits" does not align with the wording in the associated
11
enterprises articles in the tax treaties concluded by South Africa (South Africa Chartered Accountant, 2014).
Due to globalisation, foreign companies are investing in South African companies
or creating South African subsidiaries and the inconsistencies of the transfer
pricing rules between their countries and those of South Africa can be frustrating.
These inconsistencies may lead to disinvestments, therefore it is fundamental for
South Africa's transfer pricing laws to be in line with international standards.
Profit shifting has continued to grow and it's causing harm in South Africa's
economy. It's either that South Africa's transfer pricing laws are ineffective or they
are too complicated for taxpayers. A detailed analysis of South Africa's transfer
pricing laws will assist in diagnosing the root cause of the growth in profit shifting
and tax base erosion. It will also be worthwhile to look at other tax authorities and
the OECD to verify that South Africa's transfer pricing laws are aligned with
international standards. We may also have to revisit our double tax agreements,
to ensure that they do not encourage the increase of profit shifting.
The focus of this report is to determine whether the South Africa's transfer pricing
rules are able to address the challenges posed by BEPS.
1.3 THE SUB-PROBLEMS
1 .3.1 This research will analyse the impact of the allocation of taxable profits to
locations different from those where the actual business activity takes place
and how current tax laws can be adjusted to eliminate the unreasonable tax
avoidance by taxpayers. The writer will look at the remedies available to SARS
where such a contrived transaction has been entered into. A critical analysis of
the new Section 31 of the Income Tax Act will be done in order to ascertain
whether:
• It's clear and easy to understand;
• Its effectiveness in addressing profit shifting. This would be done by
ascertaining whether South African transfer pricing laws are in line with
international best practice. A comparison will be done between South
12
Africa's transfer pricing tax laws and those of some developed countries
like USA and UK
• It's able to achieve its objective.
As the world is affected by BEPS, it's important to understand South Africa's
exposure to BEPS and ascertain if South Africa's tax laws are stringent enough
to safeguard the economy from BEPS.
1 .3.2 A comparison will be done between the old and the new Section 31 of the
Income Tax Act. An analysis will be done to ascertain whether it was necessary
to amend the old section and if the new changes will improve compliance and
reduce profit shifting.
It is yet to be seen how the new Section 31 of the Income Tax Act would be
able to address challenges posed by BEPS, therefore this necessitate the
importance of doing a literature review of the Section 31 .
1 .3.3 A comparison will be done between transfer pricing rules in South Africa and
other major economies. English speaking countries that are leading tax
jurisdictions with high Gross Domestic Product (GDP), being the United States
of America (USA) and the United Kingdom (UK) have been selected for the
purposes of the comparison. Also, Australia was also selected for comparison,
as some of our legislation is borrowed from that country. The writer will look at
potential loopholes in the legislation of these different countries. An analysis of
the advantages and disadvantages of having an Advanced Pricing Agreement
(APA) will also be done. The writer will also look at significant judgments, both
locally and internationally. A critical analysis of precedents these judgments
have set and how they have influenced the approach that can be adopted
regarding the substance over form issue.
South Africa can't afford to be left behind while other tax authorities have
advanced tax laws which address challenges posed by BEPS. A comparison of
our tax laws is therefore significant in ensuring that our tax laws are in line with
those of major economies.
13
1.3.4 Profit shifting cannot be combated without harmony among other countries and
that is what the OECD has been striving to achieve. The writer will next look at
the role of the OECD regarding Base Erosion and Profit Shifting (BEPS). There
will be an assessment of the action plans proposed by the OECD in evaluating
the practicality of the OECD's action plan. South Africa's transfer pricing laws
will also be compared to the OECD's action plan.
Globalisation made the world to be small as most entities find themselves
interacting with stakeholders from all over the world. In ensuring that South
Africa is a good citizen of the global market we would have to ensure that our
tax laws are in line with the OECD.
1.4 PURPOSE STATEMENT
Profit shifting has continued to grow and it's causing harm in South Africa's economy.
It's either South Africa's transfer pricing laws are ineffective or they are too
complicated for taxpayers. The goal of this study is to analyse the effectiveness of
South Africa's transfer pricing laws in order to diagnose the root cause of growth in
profit shifting and tax base erosion.
This study will enable lawmakers on how to tighten transfer pricing laws in order to
minimise profit shifting. The study will assist in understanding variances between
South African's tax laws and those of other tax authorities.
1.5 RESEARCH METHODOLOGY
1.5.1 The research method adopted is of a qualitative, interpretive nature, based on a
detailed interpretation and analysis of amongst other things, case law.
An extensive literature review and analysis will be undertaken that includes the
following sources -
• Books;
• Cases;
• Electronic databases;
• Electronic resources - internet;
• Journals;
14
• Magazine articles;
• Publications;
• Statutes.
1.6 BRIEF OVERVIEW OF CHAPTERS
1.6.1 Chapter 1: Introduction
This chapter will introduce the background and significance of the research, the
problems and sub-problems identified and the research methodology used. The
research will also consist of an analysis of literature that is available on the
subject matter and a qualitative review.
1.6.2 Chapter 2: Analysis of transfer pricing legislation
With effect from 01 October 2011, South African Transfer Pricing legislation
was significantly changed by the implementation of an amendment to Section
31 to the Income Tax Act 58 of 1962. A comparison will be done between the
old and new Section 31 .
1.6.3 Chapter 3: Risk and challenges posed by base erosion and profit shifting
The purpose of this chapter is to look into the economic impact of base erosion
and profit shifting. It can be argued that to a certain extent the cause of
Greece's financial misfortunes can be attributed to tax evasion (Karnitschnig &
Stamouli 2015). Profit shifting has a potential of increasing the tax gap for a lot
of countries. Some countries are very cautious about tightening tax laws in
order not to discourage investment. This chapter will analyse the notion that
countries with strict tax laws are likely to lose direct foreign investment
compared to the so called tax havens.
1.6.4 Chapter 4: The Lack of Commercial Substance approach
This chapter examines the way in which some taxpayers avoid tax by entering
into a transaction with no commercial value. There are a number of simulated
transactions and schemes that have been created by taxpayers which involves
the claiming of excessive interest and incurring unnecessary debt or entering
into unnecessary transaction with connected parties. The Commissioner for the
15
SARS is currently imposing heavy penalties on taxpayers found to be evading
taxation as per Section 222 and 223 of the Tax Administration Act however the
effectiveness of such measures are still questionable. The chapter will analyse
whether it might be necessary to have an advance pricing agreement (APA) in
order to increase compliance. Sections BOA to SOL of Income Tax would also
be examined to ascertain the impact it might have on transfer pricing
compliance.
1.6.5 Chapter 5: Necessary actions to be taken to address base erosion and profit shifting
This study will examine possible actions that can be taken to simplify the
transfer pricing rules and to increase compliance. The OECD has already made
significant progress in trying to come up with the means of discouraging tax
avoidance. This study will critically analyse the work that has already been
done by the OECD and ascertain if it is sufficient. The transfer pricing laws of
other countries (the United State of America, the United Kingdom, and
Australia) will also be examined and assessed if it will be ideal in South Africa.
The study will also look into the court cases such as DSG and others v HMRC,
Lankhorst-Hohorst Gmbh v Finanzamt Steinfrut and CSARS v NWK Ltd. A
critical analysis will be done on the precedence that has been set by the
outcome of these court cases.
1.6.6 Chapter 6: Conclusion
This chapter will summarise the findings of the research, suggest
recommendations and propose areas requiring further research.
16
2.1 Introduction
CHAPTER 2
ANALYSIS OF SECTION 31
Transfer pricing legislation was implemented to address tax avoidance resulting from
intercompany transactions across borders. The lawmakers decided to make
amendments to Section 31 of the Income Tax Act in 2012. The amended wording in
the new Section 31 of the Income Tax Act, which is effective from 01 April 2012,
changed the structure of the section but not the fundamental principles. The author
would analyse the new Section 31 and also compare it will the previous legislation in
order to assess if it's able to halt base erosion and profit shifting.
2.2 The concept of transfer pricing
2.2.1 Introduction
Globalisation created an environment whereby entities have representation throughout
the world. This resulted in entities acquiring subsidiaries and establishing subsidiaries
in other countries in order to grow revenue. Some multinational companies are
targeting countries with low tax rates by shifting their profits to these so called tax
havens in order to reduce their tax liability. The prices of items sold between
connected companies might not be at arm's length as this is usually done in order to
reduce the tax liability. This can be illustrated in the example below:
Take a beverage company located, say, in Mexico, which has a subsidiary in France. Let's assume that the French subsidiary pays royalties to the Mexican headquarters for the rights to sell its drinks.Taxes are owed in France based on the French subsidiary's results. The higher the royalties paid by the French subsidiary, the lower the taxable profits in France. The French tax authorities will be satisfied if they see that the royalties paid by the French company to its headquarters in Mexico are not higher than those that would be paid to an independent enterprise for a similar transaction. But if the royalties are too high, there is a possibility that profits are being shifted out of France to reduce tax liabilities there. The "arm's length principle" is used to address such issues. Under the arm's length principle, one compares the remuneration from cross border controlled transactions within multinationals with the remuneration from transactions made between independent enterprises in similar circumstances (Silberztein n.d)
17
Transfer pricing legislation was designed to ensure that intercompany transactions
across borders are at arm's lengths and there is no profit shifting between different
jurisdictions.
It is critical for Section 31 to properly address profit shifting otherwise there will be a
major loss to the fiscus. According to Schussler (2012) South Africa's companies pay
the second highest effective tax rate among the biggest 60 economies in the world.
This means that South Africa is among the countries with a high tax rate, therefore it is
likely that companies operating in South Africa would consider shifting profit to
jurisdictions with lower tax rates.
2.3 Old transfer pricing rules
2.3.1 Introduction
The new Section 31 came into operation on 1 April 2012. This meant the principles
that were proposed by the old legislation would have to be disregarded. A brief
summary of the old legislation will enable us to ascertain whether the new legislation
is progressive and there won't be recurring errors from the previous legislation, if any.
The old Section 31 focused on ensuring that a transfer price charged by connected
parties is at an arm's length. The previous section granted the Commissioner of SARS
the discretion to adjust the price paid should he or she not be satisfied that it reflected
an arm's length price. The old section deemed such an adjusted amount to be a
dividend which was historically subject to secondary tax on companies (Hart 2014)
2.3.1 The necessity for changing Section 31
The old Section 31 of the Income Tax Act had to be modernised in order to ensure
that South African transfer pricing laws are in line with the latest transfer pricing
guidelines issued by the OECD. In terms of the old Section 31, the concept of arm's
length was linked to price and not necessary the transaction, operation or scheme
entered into on terms and conditions which would have applied had the parties
involved been independent persons dealing with each other at arm's length
18
(Steenkamp n.d.) This meant should a difference occur or a tax benefit result to one of
the parties, the taxpayer is required to calculate their taxable income based on the
arm's length terms and conditions of the affected transaction.
The wording of the old legislation was causing structural problems and uncertainty, as
the literal wording unduly focused on isolated transactions as opposed to
arrangements driven by an overarching profit objective. In addition, the language gave
rise to an excessive emphasis of the comparable uncontrolled price (CUP) method as
opposed to other more practical transfer pricing methodologies. By not looking into the
whole arrangement, SARS could overlook simulated transactions which have
unprecedented terms and conditions.
The old Section 31 provided that the Commissioner could adjust the consideration in
respect of the transaction to reflect an arm's length price for the goods or services.
This meant that taxpayers were not obliged to make the adjustments on their tax
returns for transactions even if such transactions were not conducted on an arm's
length basis. Taxpayers could therefore file tax returns with excessive deductions, and
then sit and wait and hope for the best - which would be that the Commissioner did not
pick up these excessive deductions. The Commissioner doesn't have capacity to
review all the return submitted by multinational entities, therefore a number of entities
might not comply with transfer pricing legislation and still not be picked up for a tax
audit.
Therefore it is clear that the old legislation had a number of challenges and it was
necessary to make amendments in order to address the shortcomings of the old
Section 31 . Some taxpayers took advantage of the old Section 31 by conducting
aggressive tax planning, which involved shifting extensive amount of profit into tax
havens. The legislation did not concern its self with ensuring that the terms and
conditions of the whole arrangements conducted by South African taxpayers with their
foreign related entities are normal and are not conducted with the motive of obtaining
a tax benefit. Moreover, SARS was heavily burdened with checking that all the
transactions were at arm's length and had to process all the necessary adjustments
into the taxpayers return.
2.4 The new transfer pricing rules
19
In order to eliminate uncertainties brought by the old legislation, the new rules have
been worded similarly to the wording of Article 9 of the OECD Model Tax Convention
on Income and on Capital (OECD 2015), with the focus on the economic substance of
the arrangements between related parties, rather than the pricing of specific
transactions.
The new Section 31 will be applicable whereby:
• Any transaction, operation, scheme, agreement or understanding has been
directly or indirectly entered into between connected persons with a cross
border nexus;
• Any term or condition of that transaction, operation, scheme, agreement or
understanding is different from any term or condition that would have existed
had those parties been independent persons dealing at arm's length; and
• The transaction, operation, scheme, agreement or understanding results or will
result in a tax benefit being derived by any party to it.
The new Section 31 successfully shifts the focus from separate transactions to the
entity-based approach desired by SARS. Section 31 (2) of the Income Tax Act
provides that the new rules are to apply to an "affected transaction" if (i) any term or
condition of that transaction is different from what would have been agreed to between
independent persons dealing at arm's length, and (ii) it results in any tax benefit being
derived by a person who is party to the transaction, operation, scheme, agreement or
understanding. Analysing the new wording leads one to believe that the arm's length
principle is more far-reaching than before; being applicable to any party to a
transaction, operation, scheme, agreement or understanding. Large corporates will
now be required to ensure that the overall transaction does not result in an undue tax
benefit that is contrary to the arm's length principle (Hart 2014). Aggressive taxpayer
can get into transactions which are not commercially viable in other to obtain a tax
benefit, the new legislation will assist in ensuring that such transactions are
challenged and profit shifting is halted.
20
The new rules stipulate that the taxable income of a party to the affected transaction
who derives a tax benefit must be calculated as if the affected transaction had been
entered into on the terms and conditions that are expected between parties dealing
with each other on an arm's length basis. This requirement effectively removes the
Commissioner's discretion to make an adjustment and shifts the responsibility to make
a voluntary transfer pricing adjustment onto each party to the transaction. Determining
whether the terms and conditions of a transaction are different to what would have
been agreed to between independent persons dealing at arm's length might not
always be an easy excise to conduct. Certain businesses don't have a standard model
and therefore it might be difficult to come up with a benchmark. For example, a bank
might fund Project A at 11 % interest rate, with a 5 year payment term, while Project B
might be funded at 8% interest rate, with a 5 year payment term. Should a connected
foreign entity decides to run Project C, it will be difficult to ascertain an appropriate
interest rate that will convince SARS that the transaction is at arm's length. (Hart
2014)
Transfer pricing adjustments (whether voluntary or through a SARS audit) are no
longer considered to be a deemed dividend, but rather the adjusted amount is seen to
be a loan on which interest is due (on an arm's length basis). The interest to be
charged on this deemed loan may be discharged if the loan is repaid in the same
financial year. This further indicates that the interest charge will be indefinite, pending
the settlement of the debt created through the adjustment (Hart 2014).
21
CHAPTER 3
Risks and challenges posed by base erosion and profit shifting
3.1 Introduction
BEPS poses a serious risk to a number of countries, especially the developing
countries like South Africa. Government expenditure should mainly be funded by tax
revenue instead of borrowed funds, for a country to have a healthy financial status,
this impact of BEPS might make it hard for a lot of countries to attain this. The purpose
of this chapter is to look into the economic impact of base erosion and profit shifting
and the challenges that it poses to society at large.
3.2 The economic impact of BEPS
It can be argued that BEPS is one of the causes of many countries' recent financial
hardships. In the Davis Tax Committee Interim Report (2014), it is stated that
Tax Justice Network report "The Missing Billions" which estimates that GBP12 billion of corporate income tax is lost each year due to tax avoidance by the 700 largest companies in the United Kingdom. For developing countries Oxfam, a non-profit organisation, attributes a revenue loss of USD50 billion to tax avoidance by multinationals (Davis Tax Committee Interim Report, 2014).
This is a serious challenge for many states, as the government can't deliver on its
mandate without having financial resources. According to the Tax Justice Network
report, few issues can be more important to a modern democracy than the integrity of
its tax system. It is deeply troubling, therefore, to discover that the tax system is being
increasingly undermined by the practice of tax avoidance.
The gap between the rich and poor people will increase even further if BEPS is not
properly addressed.
Tax justice and the struggle against tax havens has to be a central part of any inequalityfocused agenda. With some $21-32 trillion in financial assets sitting offshore, largely untaxed, the offshore system of tax havens clearly has mind-bending effects on inequality within and between countries. All that offshore wealth is held by the world's 10 million wealthiest people: and a large share of that by the wealthiest 100,000. Because of tax havens, inequality is certainly significantly worse than what economists measure (read more about that here). Worse still, tax competition is 'compressing' tax systems around the world, with the effect of reducing tax rates on the wealthy and increasing tax rates on the poor. Many other unjust features of tax systems make the problem still worse: corporate tax avoidance, for instance, routinely facilitated by offshore tax shenanigans (Tax Justice Network n.d)
22
Some Global multinational enterprises (MNEs) are obsessed with accumulating wealth
and they have no regard for economic upliftment in countries where they operate.
MNEs need to realise that paying their fair share of tax is to their benefit. A country
with an effective economic system will enable citizens to have buying power which
would enable them to buy MNEs' products.
3.3 Tax havens impact on the spread of BEPS
Tax haven can be defined as a 'country with little or no taxation that offers foreign
individuals or corporations residency so that they can avoid tax at home'. Naturally,
most MNEs would prefer to be in countries where they would pay little or no taxation.
Does this mean countries should compete to have the lowest tax possible in order to
attract foreign investors or would minimum tax revenue received by these countries
collapse their economy?
The Republic of Ireland can be regarded as a tax haven as they have a 12.5%
corporate tax rate, which is lower than international standard's. Ireland is one of the
worst tax havens in the world, it has helped big business to dodge billions of euro.
Bermuda and the Cayman are also used by some big businesses to avoid tax (Irish
Times 2016). Ireland came out of the economic crisis as one of the best performing
economies, with GDP growth rates of 8.5% in 2014 and an extraordinary 26.3% in
2015 (Tax Justice Network 2017). Moreover, it is important to note that Ireland is an
economy dominated by foreign companies. The foreign controlled affiliates provide
almost 50% of employment in the country and 80% of exports (90% of manufacturing
exports), it is clear that foreign investment is plays a significant role in Ireland's
economy. This, combined with Ireland's status as a tax haven, makes Irish GDP
figures particularly vulnerable to profit shifting, therefore most companies will consider
shifting their profits in Ireland, in order to take advantage of low tax rates. Through
transfer pricing, which involves the Irish subsidiary overcharging other parts of the
company based elsewhere for goods and services, profits can be moved from the rest
of the world to Ireland. It can be argued that this kind of internal profits shifting does
very little for the domestic workforce. In some certain cases you would notice that
headquarter companies based in Ireland may be employing very few people or not
23
employing anyone at all. What is even more disappointing is that profits declared in
Ireland are likely to quickly be taken out of the country again (Tax Justice Network
2017).
It can be noticed that tax havens don't really benefit from having little or no taxation.
Moving MNEs headquarters to a tax haven doesn't necessary mean the citizens would
benefit from job creation. The main beneficiaries of BEPS are the MNEs. They pocket
maximum profits without paying their fair share of tax. Employment in Ireland could not
reach crisis levels in Ireland, despite the fact that the country has been experiencing
net emigration, which should decrease the work force. It was also noticed that the
wage share, that is the amount of national income that is paid out as wages, has
declined severely. This means investors did not born the economic costs provoked by
the financial crisis (Tax Justice Network 2017)
The Republic of Ireland's GDP growth, as a tax heaven, is questionable and is it even
possible for countries to follow the Irish development model, which relies on
freeloading of profits earned elsewhere.
This result puts the Irish role as a blueprint for other countries into question. Ireland's strategy of attracting foreign owned companies by low corporate taxation rates can be seen as a beggar-they neighbour strategy, increasing downward competition for taxation in the EU. The strategy is not even clearly positive for Irish citizens, at least not for those relying on wage income. Therefore, it is surprising that the government seems to be willing to continue to compete for foreign owned companies by low corporate taxation rates, as a series of publications of the Department of Finance (2014) seems to indicate as well as the discussion of having to accept tax payments of Apple (Tax Justice Network 2017)
Tax heavens enable the spread of BEPS and they don't get meaningful benefit from it.
We don't have an international watchdog that can stop countries from becoming tax
havens. Perhaps all countries should decide to be tax heavens, then no country would
be a tax haven, however this won't benefit anyone, except for the MNEs.
The top 1 O countries with the highest gross domestic product (Statistics times, 2017)
have an average tax rate of 27% (OECD, 2017). This is a clear indication that a
healthy tax rate has a significant impact on the countries' GDP growth. It is no surprise
that none of the countries who are considered to be tax havens feature in the top 1 O
countries with the highest GDP.
24
Top 10 countries with the highest GDP
Corporate Country GDP (billions of $) Tax rates
United 19,417,144 35% + 0-States 12%
China 11,795.297 25% Japan 4,841,221 32% Germany 3,423,287 30%
United 2,496.757
Kingdom 20%
India 2,454.458
30% 15% (profit<
France 2,420.440 38120€)-33.00% (profit> 38120€)
Brazil 2,140.940 34%
Italy 1,807.425 27.50% 15% -26%
Canada 1,600.265 federal+ 11-16% provincial
One sees a different picture when you look at GDP per Capita. According to the
National Bureau of Economic Research, tax havens feature in the top 11 countries
with the highest GDP per Capita.
The major tax havens have a lower population, they have less than one percent of the world's population (outside the United States), and 2.3 percent of world GDP, but host 5.7 percent of the foreign employment and 8.4 percent of foreign property, plant and equipment of American firms. The low population in tax havens makes it easy for tax havens to lower tax rates. Per capita real GDP in tax haven countries grew at an average annual rate of 3.3 percent between 1982 and 1999, which compares favourably to the world average of 1.4 percent. The growth rate of tax haven is more than double of the average growth rate of the world. It can be noticed that tax havens tend to attract a lot of foreign investment. It can be argued that high tax countries indirectly contribute to the economic prosperity of tax (Hines n.d)
25
Top 11 countries with highest GDP per capita
1 Qatar $129 700
2. Luxembourg $102 000
3 Macau $96 100
4 Liechtenstein $89 400
5 Singapore $87 100
6 Bermuda $85 700
7 Isle of Man $83 100
8 Brunei $79 700
9 Monaco $78 700
10 Kuwait $71 300
11 Ireland $69 400
Table from Central Intelligence Agency 2016
3.3 Impact of strict tax laws on investment
One would expect foreign investors to consider the tax system of the potential country
they are intending to invest in. It's not easy to measure effects of tax factors on
transatlantic investments is accurate beyond the obvious one that taxation is always
relevant. When it comes to foreign investment, tax considerations are seldom
dominant, and in most cases, differences in taxation are usually negligible. Meeting
reporting requirements of different tax jurisdictions may discourage foreign investment,
however obtaining a tax benefit more important than tax differences in investment
decisions. (Smith n.d)
Though tax might not be the main factor in influencing foreign investor's decisions
however it still plays a critical role in the decision taken by the investor on whether to
invest in a particular country or not. Therefore it is important for every country to
ensure that they implement tax policies that are foreign investment friendly. This does
not mean countries need to expose themselves to profit shifting activities that are
conducted by some of the MNEs. There critical question is how to strike a balance
between having strict tax laws and still be able to encourage foreign investment. It is in
every countries interest to have foreign investors.
Most government believes it is important to focus on attracting foreign direct
investment (FOi). The advantage of having more foreign investment is a reduction in
26
unemployment, economic growth and infrastructure development. FOi is very
important for governments as it contributes to the domestic country's income through
introduction of new technologies and skills development. It is therefore important for
the policy makers to ensure that tax laws are friendly toward foreign investors, in order
to take advantage of the FOi. In trying to attract FOi, it is important for government to
ensure that they still attain appropriate share of domestic tax from MNEs. While
offering a competitive tax environment, it is important to ensure that the country's
economy is not disadvantaged.
One of the major considerations in the analysis done by foreign investors would be the
tax rate. The increase or decrease in the tax rate would have an impact on the
investor's attitude towards a country. Foreign direct investment is like to decrease
following an increase in tax rate on FOi, as they are becoming increasingly sensitive to
taxation. When evaluation how FOi react to tax reform, it's not easy to ascertain how
tax factors into FOi decisions, and what tax rates which investors consider to be
reasonable. In most cases the comparisons may focus on statutory corporate income
tax (CIT) rates and little attention might be given to indirect taxes. Or it may be that
average effective tax rates or marginal effective tax rates matter more than corporate
income tax (headline rates), as they play a significant role in the determination of the
percentage of profits that are taxable. Corporate income tax rates may differ
significantly from effective tax rates, to the extent that taxable profits differ from the
real profits, therefore some investors look beyond the CIT rate, they also consider the
expenses that are deductible, as they are interested in the effective interest rate.
(OECO n.d)
Foreign investors compare the economic climate of different countries and invest on
countries that have tax policies that a conducive to their needs. In today's global
business environment, tax competition for FOi exists and government always need to
take it into consideration when introducing tax policies. Governments can't make a
mistake of thinking that investors don't conduct a comparison of tax policies across
countries that are similar in location and market size.
27
CHAPTER4
Lack of commercial substance
4.1 Introduction
The way of doing business has evolved over the years and this requires the tax
legislation to be amended in order to keep up with changes that have emerged. It is
becoming difficult to place absolute reliance on old court cases to address the current
complex business transactions. Most taxpayers are constantly looking for loopholes in
the tax legislation in order to minimize their tax liability. Moreover the current economic
crisis has also served as a motive for taxpayer to get involved in transactions that
would result in minimum or no tax expenses. South Africa might have a reduction in
simulated transactions if the Advance Pricing Agreements (APAs) proves to be
advantageous. The impact of general anti-avoidance rules on simulated transaction
need to be analysed, in order to ascertain if they need to be tightened.
4.2 Simulating transactions to achieve BEPS
Most taxpayers avoid tax by entering into contracts that disguised their true nature in
order to qualify for a tax benefit that would not be available if the true contract between
them were revealed (SAICA 2009). Transactions that lack commercial substance are
often simulated.
There's no definition of simulated transaction in the Income Tax Act and therefore we
rely on court cases to ascertain whether a transaction was simulated. In a string of
cases such as Zandberg v van Zyl 1910, Commissioner of Customs and Excise v
Randles, Brothers and Hudson Ltd, it was understood that a transaction will not be
regarded as simulated if the parties genuinely intended that their contract will have the
effect in accordance with its tenor and the rule applies even if the transaction is
devised solely for the purpose of avoiding tax. There are a number of gaps that can be
found in the above principle. The mere fact that the parties genuinely intended to
execute what is in the contract should not protect a transaction from being regarded
as simulated.
28
During the C:SARS V NWK Ltd 2011 court case, Lewis JA stated that if the purpose of
the transaction is only to allow the avoidance of tax, then the transaction will be
regarded as simulated. Transactions that involve prices which are not at arm's length
are often lacking commercial substance and they are simulated transactions. The
purpose of schemes or transaction formed to achieve profit shifting is to avoid tax and
therefore they meet the definition of simulated transactions.
Practice Note 5 states that a taxpayer who has carried out a legitimate tax avoidance scheme i.e. who has arranged his affairs so as to minimise his liability, in a manner which does not involve fraud, dishonesty, misrepresentation or other actions designed to mislead the Commissioner, will have met his duties and obligations under the Act (Department of finance, 1987).
This means if a taxpayer structure their transaction in a way that would minimise the tax liability, the taxpayer won't be at fault if it's a legitimate tax avoidance scheme.
It's not clear cut what would constitute a simulated transaction which lacks commercial
substance. Courts are usually requested to resolved disputes between taxpayers and
the tax authorities to resolve matters relating to simulated transactions. Transactions
relating to profit shifting usually lack commercial substance e.g goods are not sold at
market related prices to connected parties. Tightening the general anti-avoidance
rules which are contained in sections 80A to 80L of the Income Tax Act legislation
dealing with simulated transaction would therefore play a critical role in eliminating
profit shifting.
4.3 Advance Pricing Agreement.
According to the OECD's guideline for Advanced Pricing Agreement (APA), an APA is an administrative approach that attempts to prevent transfer pricing disputes from arising by
determining criteria for applying the arm's length principle to transactions in advance of those transactions taking place (OECD n.d).
The South African Revenue Service (SARS) does not enter into advance pricing
agreements with taxpayers at the moment. In trying to ensure that taxpayers are
comfortable about their transfer pricing approach and methods used to arrive at an
arm's-length price, jurisdictions such as the United Kingdom and the United States of
America, make use of 'Advance Pricing Agreements' ('APAs'). Having APAs proved to
be helpful in resolving transfer-pricing disputes. Unfortunately APAs are currently not
in use in South Africa and SARS doesn't seem to be keen on introducing it in the
foreseeable future. This means South African taxpayers are currently not able to
benefit from the advantages of having an APA. (Oguttu n.d)
29
Denying taxpayers an opportunity to enter into these agreements has advantages and
disadvantages. It is important to do a detailed analysis to ascertain whether it would
be worthwhile for South Africa to incorporate APAs in the Tax Administration Act.
4.3.1 Advantages of APAs
The APAs offer better assurance on transfer pricing methods and are conducive in
providing certainty and unanimity of approach (Garg 2016). Having APAs avoids
unnecessary audits which waste both the taxpayers and the tax authorities' time. This
would also enable taxpayers to do proper tax planning and remove uncertainties. The
basic idea behind having an APA is to increase the efficiency of tax administration by
encouraging taxpayers to voluntary disclose before the tax authorities all the facts
relating to their affected transactions, this would then enable a taxpayer to work
towards a mutual agreement. Tax authorities also benefit from having an APA, as it
reduces the burden of compliance. This means there will be a reduction in the number
of transfer pricing audits. Having an APA also gives taxpayers greater certainty
regarding their transfer pricing methods, as it is always a challenge to choose an
appropriate method, moreover an APA gives a platform to the taxpayer and the tax
authorities to have a discussion and a resolution in advance.
A significant amount money is spent on transfer pricing audit, tax administrator have to
allocate lot of resources to resolve transfer pricing disputes and this could be avoided
through the introduction of transfer pricing. The developed countries like the United
States of America and the United Kingdom adopted APA, one would expect a
developing country like South Africa would to the same, so as to take advantage of the
benefits listed below
• Complex and high risk transactions are addressed and resolved early-APA
enable taxpayers to minimize the risk of a transfer pricing adjustment and they
provide certainty through a negotiation process. APAs are likely to be
undertaken by companies that have extremely complex inter-company
transactions, which have a high degree of transfer pricing adjustment risk that
30
may result in penalties. Having APA would ensure that taxpayers have certainty
with regard to their transfer pricing policies.
• An APA will assist with avoiding double taxation - Most Multinationals' pricing
of goods and services for transactions among themselves are usually governed
by a global pricing policy. These global policies generally ensures to provide an
arm's length return to various constituents of the MNE group, based on the
functions performed, assets employed and risks assumed by each member of
the group. When a revenue authority in a particular jurisdiction audits and
disputes such pricing policy and raises a consequential demand, it might lead
to double taxation for the Group as a whole. The process of APA will play a
significant role in doing avoiding a situation whereby there is a double taxation.
• Taxpayers will avoid costs relating to tax audits - Tax audits are costly and
APA will reduce compliance cost and costs associated with audit and appeals
by eliminating the risk of transfer pricing audit and resolving unnecessary time
consuming disputes and litigations. This will also help revenue to allocate their
resources on other things
• Transfer pricing documents require a lot of record keeping, having an APA will
certainly reduce the burden of record keeping as taxpayer will knows in
advance the required documents to be maintained to substantiate the agreed
terms and conditions of the agreement.
• The negotiation between the taxpayer and revenue authority is good for both
parties as the authorities get to understand the business better and the
taxpayer can learn from competent authority guides on how transactions should
be structure in order to ensure that prices for goods and service are at arm's
length.
(Garg 2016)
APAs would also play a significant role in reducing simulated transactions. The
reduction in compliance cost that would encourage taxpayers to rather enter into an
APA instead of participating in simulated transactions which may result in heavy
penalties.
31
4.3.2 Disadvantages of APA
APAs can also be disadvantageous, they require extensive voluntary disclosure and
this could result in concern about exposure to adjustments for open tax years. In most
cases the non-factual representations made during the APA process cannot be used
as evidence in legal or administrative proceedings, unless the proceedings regard a
tax year, transaction and person covered by a successfully completed APA (Hansen
n.d).
The disclosure process can also be expensive and time consuming because the
disclosure is generally more extensive than for private letter ruling. This means a
taxpayer would have to pay for provisional fees, expert opinion fees and employees'
salaries.
The advantages of having APAs seem to outweigh the disadvantage and it would be
worthwhile for South Africa to consider implementing it. This would also ensure that
South Africa's legislation is in line with that of the developed countries.
32
CHAPTERS
Actions to be taken to address base erosion and profit shifting
5.1 Introduction
Base erosion and profit shifting (BEPS) by multinational corporations has entered the
public consciousness as a potentially important impediment to tax collections (Hines
n.d). Therefore it is critical for BEPS to be urgently addressed in order to end further
loses to the fiscus. The impact of BEPS on tax revenues is not easily quantified.
MNEs are going all out to ensure that they to ensure they pay minimum or no tax in
order for more profit to be allocated to shareholders. This means that a corporation
that is located in a country with a 20 percent tax rate, and that has the opportunity to
reallocate some of its taxable income to a country with a 15 percent tax rate, will
typically arrange its financial and other affairs to reallocate most of its income to the
lower-rate country. According to JR Hine (n.d.), the average member country of the
OECD in 2011 raised 8.8 percent of its total tax revenue from taxes on corporate
profits, portion of which represented taxes on multinational corporations. The tax
contribution of Multinational Corporation might seem lower, however any form of
contribution to Tax Revenue makes a difference.
The development of a country like South Africa is depended on tax revenue to be able
to finance government expenditure. A shortfall in tax revenue caused by BEPS would
further deteriorate South Africa's economic growth plans. Simplifying transfer pricing
rules and ensuring they are in line with OECD would play an important role in
increasing compliance. Aligning our transfer pricing law with that of other countries'
would enable us to stay abreast will the latest trends.
5.2 Modification of transfer pricing rules.
According to the OECD, it is important for countries to understand modern business
models and how MNEs operate in a globalised economy in order to curtail BEPS.
Globalisation, the gradual removal of trade barriers, the increase in technological and
telecommunication developments has caused products and operational models to
evolve, changing the way modern MNEs are structured and managed and thereby
33
creating the conditions for the development of global strategies aimed at maximising
South Africa's TP legislation is contained in Section 31 of the Income Tax Act 58 of
1962 and is supported by SAAS Practice Note 7, which outlines the important
principles and guidelines that taxpayers have to follow in determining an arm's length
price. South Africa's transfer pricing laws were enacted in 1995 and Practice Note 7
was released in 1999, until recently there were no changes in the legislating to still
remain relevant in the modern way of doing business. The changes that were recently
made, which became effective as of the 1 April 2012 is focusing on all aspect of the
contracting parties and not only on the pricing of transactions. The other changes in
the TP legislation relates to the triggering of TP adjustments and the consequences
for a South African taxpayer entity of such an adjustment. Transfer pricing
adjustments will have to be made by the taxpayer that is party to the affected
transaction in its tax return. This is different from the previous rules, which prohibited
taxpayers from making Transfer Pricing adjustment themselves, but rather provided
the SAAS with the discretion to make such an adjustment if SAAS was of the opinion
that the transaction had not been priced on an arm's length basis.
There are still gaps in South Africa's transfer pricing legislation, as the following issues
are not property addressed, as required by the OECD. (Deloitte, 2016)
• Transfer pricing rules prevent excessive interest deduction. However the
currently legislative environment is complex and could create uncertainties for
taxpayers (Action 4)
• There was no clarity on which entities are supposed to have a TP document
and what should be contained in the document. A public notice was recently
issues which indicated that transfer pricing documentation would be required If
an entity enters into a potentially affected transaction and the aggregate of the
person's potentially affected transactions for the year of assessment, without
offsetting any potentially affected transactions against one another, exceeds or
is reasonably expected to exceed R100 million. This only applies to
assessment relating to periods after 1 October 2016 (Action 13).
34
• Draft regulation that specifies country by country reporting standards for
multinational enterprises was published on the 11th of April 2016. The
regulations are effective from tax years beginning on or after 1st January 2016.
The first CBC reports must be filed by 31 December 201 ?(Action 13).
• South Africa's CFC rules are complex and in some respect unclear, so the
application of the recommendation in the report on Action 3 may welcome in
helping to overhaul the legislation. However it is not clear whether South Africa
would make any changes to the current rules (Action 3).
5.3 Comparison of South Africa's transfer pricing rules with those of developed
countries
5.3.1 United State of America (USA)
The USA is very experienced when it comes to transfer pricing, as it has one of the
oldest and most mature transfer pricing regime in the world. (KPMG, 2015 a)
There a number of similarities between South Africa and the USA's transfer pricing
rules, below are the differences that were identified by the author. South African might
have to look into these differences and perhaps consider amending its transfer pricing
rules.
5.3.1.1 Affected transactions:
According to the USA's laws, the parties must be under common control. Control is
based on a facts and circumstances test, and not on specific ownership thresholds.
Currently, South African laws only look at ownership and do not consider a facts and
circumstances test. This means a number of transactions could be left unchallenged.
5.3.1.2 Preferable benchmarking set
The tax authorities in USA have a preference for local comparable benchmarking set.
The IRS expects that's to use US comparable to be used to benchmark a US tested
party, in certain instances, the Canadian comparable can be used. Moreover there are
detailed reporting requirement for public corporations that are used by providers who
35
create company databases and by practitioners who prepare transfer pricing reports.
(KPMG, 2015 a)
Having a standard comparable benchmarking is critical because it avoids a situation
whereby taxpayers could manipulate the benchmarking to suit their desired outcome.
South Africa lawmakers would have to consider adopting the same approach.
5.3.1.3 Advanced Pricing agreements
APA is a very important program that ensures that taxpayers comply with transfer
pricing laws and it enables companies incorporated in USA to reduce the transfer
pricing risk. According to the KPMG report, it was noticed that the I RS received 108
APA requests in 2014. Therefore it is clear that APAs remain an important instrument
that can be used by the authorities to achieve certainty and mitigate transfer pricing
risk for many multinationals. (KPMG 2015 )
This is testament to the fact that the introduction of APAs would accelerate efforts of
ensuring that multinationals comply with transfer pricing legislation. The IRS's
combination of the Advance Pricing Agreement (APA) program and the competent
authority program into a newly created group, the Advance Pricing & Mutual
Agreement program (APMA), has reduced long court dispute which require lot of
money to be spent on litigation fees. A more expedited processing and resolution of
transfer pricing disputes has now been facilitated by the APMA. A proposed guidance
which was issued in the late 2013 by IRS, it emphasised the importance of APMAs is
consistent with the objectives of APMA to enhance integration between competent
authority matters and APAs, to improve allocation of resources, and to increase
transparency and efficiency (KPMG n.d).
36
5.3.2 United Kingdom {UK)
The transfer pricing legislation was introduced in April 2008. (KPMG n.d). Given the
length of time that the transfer pricing legislation has been established in UK, South
Africa can look into UK's transfer pricing tax laws for guidance as some of South
Africa's laws are based on UK's laws. South Africa, like many other countries, bases
certain of their efforts to establish and implement domestic taxation rules and
regulations on the experience of the UK. In the past, South Africa has looked into a
country like the UK, in developing and enacting of most of income tax provisions and it
is therefore expected that it should also be the case when it comes to transfer pricing.
As an OECD member country, UK Income Tax Legislation on transfer pricing
emphasise and encourage the arm's length principle. The transfer pricing legislation is
based on a self-assessment system which requires all companies to determine
whether their intergroup transactions are always carried at arm's length. When
transfer pricing was first introduced to the UK, it was only in respect of cross-border
intergroup transactions. An amendment was done to the UK transfer pricing legislation
on April 2004, the amendment addressed deficiencies in the introductory legislation
which failed to counter a range of UK tax planning structures that allowed companies
to shift profits domestically to benefit from assessed tax losses. The scope of Transfer
pricing legislation is now broader as domestic transactions have been included,
providing the UK with one of the most aggressive transfer pricing regulation systems.
(Spearman 2013)
5.3.2.1 Advance pricing agreements
Similar to the transfer pricing laws in USA, the transfer price laws in the UK makes
provision for APA. The UK has had formal APA procedures since 1999.
5.3.2.1 Affected transactions:
According to UK's transfer pricing laws, the transfer pricing rules would apply when
the following conditions are met:
• A provision has been made or imposed between two persons by means of a
transaction or series of transactions;
37
• One of those persons was directly or indirectly participating in the management,
control and capital of the other, or the same person or persons were directly or
indirectly participating in the management, control and capital of both parties to
the provision;
• The actual provision differs from the arm's length provision which would have
been made between different enterprises and;
• The difference gives rise to a potential UK tax advantage.
The UK's affected transactions conditions are fairly similar to those of South African.
However there are developments and trends that South African lawmakers need to
take cognisance of.
5.3.3 Australia
Australia introduced new rules which apply to income tax years beginning on or after 1
July 2013. There are few differences between South Africa's transfer pricing laws with
those of Australia.
5.3.3.1 Affected transactions
The parties involved in relevant transfer pricing arrangements need not to be related
to one another and there are no control requirements or ownership threshold under
Australian laws (Deloitte 2015). This is something South Africa should consider
introducing as it would assist in eliminating schemes arranged by unrelated parties.
The statute of limitations on assessment of transfer pricing adjustments is seven years
while in South Africa its three years, unless SARS can prove that the taxpayer was
involved in fraud or there was misrepresentation.
5.3.3.2 Advance pricing agreement
Australian also has an APA program which is currently being updated to reflect
changes to the global economy, community and ATO's profit shifting work. Under the
38
ATO's Advance Pricing Agreement (APA) program, a taxpayer with an APA is
required to prepare and submit an Annual Compliance Report to the ATO disclosing
the covered transactions, according to the requirements of Practice Statement Law
Administration PS LA 2015/4. There is no formal requirement for taxpayers to provide
their transfer pricing documentation to the ATO with the tax return (KPMG 2015 b).
5.4 Progress made by OECD
The Organisation for European Economic Co-operation (OEEC) was established in
1947 to run the US-financed marshal plan for the reconstruction of continent ravaged
by war. It paved a way for a new era of cooperation that was to change the face of
Europe. Encouraged by its success and the prospect of carrying its work forward on a
global stage, other countries like Canada and the US joined OEEC members in
signing the new OECD Convention on December 14, 1960. The OECD was officially
established on September 30, 1961, when the Convention entered into force
(Telegraph, 2011 ). OECD plays a significant role in ensuring that the international
community works together to address global challenges.
With regards to dealing with BEPS, the most notable work done by the OECD is the
introduction of action plans that can be taken by its members to combat BEPS. In the
table below, one can see the progress made by South Africa regarding the
implementation of Actions recommended by OECD.
South Africa : BEPS implementation plan (Deloitte, 2016)
Action OECD Category Notes on local country Expected timing
implementation plan
VAT on digital Common VAT Act was amended with Not yet known business approach effect from 1st of April 2017 such (Action 1) that an enterprise rendering
certain electronic services must register as a VAT vendor in South Africa and charge VAT on the supply of services. These services include ebooks, films and music. It is not know yet whether there would be any changes to the current legislations.
Hybrid (Action 2) Common South Africa already has Not yet known approach legislation addressing hybrid
instruments, althouah an expert
39
group (Davis Tax Committee 'DTC') examining the tax framework has recommended that the hybrid instrument legislation be simplified to focus on legal principles rather than specific instruments or transactions. The rules should also be in line with international leading practice.
CFCs (Action 3) Best practise South Africa's CFCs rules are Not yet know complex and in some respects, unclear, so the application of the recommendation in the report of Action 3 may be welcome in helping to overhaul the legislation. However it's currently unclear whether South Africa would make any changes to the current rules
Interest deduction Common South Africa's exchange control, Not yet know (Action 4) practise transfer pricing and income tax
rules generally prevent excessive interest deductions. However, the current legislative environment is complex and could create uncertainty for taxpayers. It is unclear whether any changes will be made.
Harmful tax practise Minimum There is some concern about the Not yet know (Action 5) standard possibility that South Africa's
headquarter company regime could constitute a harmful practice. It is not yet know when or if there will be any changes to the existing legislation.
Prevent treaty Minimum The DC has recommended that Not yet known abuse (Action 6) standard South Africa ensure that it
prevent the use of the application of domestic anti avoidance provisions in its tax treaties. The main purpose requirement in the GAAR is akin to the PPT recommended by the OECD.
The DC recommended that South Africa take steps to renegotiate its older treaties or sign protocols amending the titles and preambles of older treaties to the effect that they are not intended to create opportunities for non-taxation or reduced taxation through tax evasion or avoidance, including through treaty shopping arrangement
Permanent Revision of It would be to South Africa's Not yet known establishment existing standard benefit to incorporate the status (Action 7) changes to the definition of a PE
into all of its tax treaties.
40
Transfer pricing Revision of The exchange control regulations Not yet known (Action 8 - 10) existing standard restrict to the extent that to which
abusive arrangement can be implemented in respect of the provision of intra group intangibles. Exchange control rules require prior approval of such arrangements and transfer pricing sign off is often a prerequisite for such approval. Manufacturing royalties are subject to certain caps imposed by the department of trade and industry - generally 6% of the turnover of South African entities.
Disclosure of Best practice See action 13 below re additional Not yet finalised aggressive planning reporting requirements for but proposed to be (Action 12) Multinational Enterprises (MNEs) effective from 1
July 2017
Transfer pricing Common In July 2016, the SAAS issued a Not yet finalised documentation approach draft notice providing that where but proposed to be (Action 13) the taxpayer's aggregate effective from 1
potentially affected transaction July 2017. for a year of assessment exceed 5% of gross income or R 50 million the taxpayer will be required to keep special records, books of accounts or documents, presumably as part of its transfer pricing documentation. Significant additional reporting requirement are proposed , for example operational flows, including product flow, cash flow of the transactions, as well as comparison to the flows in independent transactions and where a tested party is outside South Africa, copies of invoices and contracts between tested parties and its customers. The notice has not vet been finalised.
CbC reporting Minimum Where the ultimate parent of the 1 January 2016 (Action 13) standard MNEs is tax resident in South
Africa and has annual consolidated turnover exceeding ZAR 10 billion during the 2015 financial year, it would be required to prepare the CbC report for financial years on or after 1 January 2016. The SAAS has confirmed that the template issued by the OECD should be used for the CbC report and the above requirement would not be applicable to South African intermediary holding companies. There are circumstances where the South African entity mav be
41
required to submit the CbC report even though it is not the ultimate parent company of the MNE. This applies to so called constitute entities and the threshold that applies is EUR 750 million. South Africa is one of the countries that signed the multilateral competent authority agreement for the automatic exchange of CbC report.
Dispute resolution Minimum While South Africa is not one of Not yet known (Action 14) standard the countries that is committed to
complemented binding arbitration in its bilateral by best standard tax treaties, South Africa has tax
treaties with most of the countries that have so committed, so those treaties may need to be amended to include the specified timeframe for the resolution of disputes.
In March 2015, the SARS published guidance on MAP procedure, including an explanation of what MAP entails and how to submit a request.
South Africa is making significant progress in trying to address the action plans
recommended by the OECD, however as it can be seen in the table above, there are
issues that still need to be addressed. The Davis Tax Committee has been tasked with
the responsibility of addressing BEPS in South Africa and the main issues that they
perhaps need to focus on are as follow:
• Simplifying the hybrid instrument legislation;
• Simplifying Controlled Foreign Company (CFC) rules;
• Simplifying transfer pricing laws relating to interest deduction, as they are
currently creating uncertainties for taxpayers;
• Reconsider negotiating old tax treaties in order to avoid treaty shopping and
also amend the Permanent Establishment definition in the treaties. Specified
timeframe for the resolution of disputes need to be included in the tax treaties.
42
5.5 Court cases
A number of court cases can be used to enable South Africa to identify areas which
require modification. Looking into the principles that come out from court cases would
help South Africa to strengthen its tax laws. Despite this length of time, transfer pricing
disputes in the United Kingdom (UK) are usually resolved by negotiation between Her
Majesty's Revenue and Customs (HMRC) and the taxpayer.
5.5.1 DSG and others v HMRC
The DSG and others v HMRC case shows that South Africa can't always place
comparables high in the ranking when trying to determine a transfer price as
recommended by the OECD Guidelines. The court cases also shows that no matter
how complex a case might be the determining an arm's length price between parties
can always be achieved. The following issues were relevant:
The case can be summarised as follow:
The DSG and others v HMRC case is relating to a dispute between HMRC and a
group of companies which form the largest retailer of electrical goods in the UK,
comprising Dixons, Currys and PC World. DSG Retail Ltd (DSG) was the retail
company and had a subsidiary, CIS. CIS, acting as agent for Cornhill Insurance pie
(Cornhill), offered DSG's customers extended warranties on electrical goods. Cornhill
paid CIS a sales commission. From May 1986 to April 1997 Cornhill was the insurer of
the extended warranties sold to DSG's customers, retaining 5% of the risk and
reinsuring 95% with a subsidiary of DSG that was incorporated in the Isle of Man,
DISL. Cornhill ceded 95% of the risk premiums it received to DISL under the
reinsurance contract, and in return DISL paid Cornhill a ceding commission of 1 .5% of
the premiums ceded to it. DSG had no direct contractual relationship with DISL.
In 1993, the arrangements were extended for five years and the profit commission
arrangements with CIS were altered so that Cornhill paid CIS a greater commission.
Cornhill agreed not to seek a corresponding increase in ceding commission from
DISL. From 1 April 1997 there was a significant increase in the rate of Insurance
43
Premium Tax ("IPT") on the goods that DSG sold from the then standard rate of 2.5%
to 17.5%. In order to avoid IPT, DSG restructured the arrangements so that instead of
an insurance policy issued by Cornhill, customers were sold a service contract with
ASL, an Isle of Man company independent of DSG. The fee that was charged for the
repair contract did not attract IPT because it was not an insurance transaction. ASL
then insured its risk with DISL
According to Chelsea Roche the case was addressing the following issues:
• Was there a provision between DSG and DISL?
• Did the actual provision differ from the provision that would have been made
between independent enterprises?
• Did the provision confer a potential advantage in relation to UK tax?
• What adjustment is required?
The decision made by the court was as follow:
The court held that there was provision between DSG and DISL even though there
being no direct contractual relationship between these entities. It became clear that
during the negotiations with Cornhill and with DSG's bargaining power, DISL had been
given an advantage in order to provide tax benefits to the whole group.
The Special Commissioners reached a conclusion and indicated that the
arrangements were not at arm's length and that DSG set a price that "confers a
potential advantage in relation to United Kingdom taxation" because DSG's profits did
not include income it would have received for its provision of the business facility if
DSG and DISL were dealing at arm's length. The comparables that were submitted by
DSG were rejected and the special commissioners supported the use of the type of
profit split formula suggested by HMRC. It was concluded that DSG's profits should be
adjusted to that of an arm's length arrangement based upon the profit split method
that was suggested by HMRC. The parties were given an opportunity to determine
the actual quantum of the adjustment in order for a settlement to be negotiated, but
the tribunal reached a decision that the adjustment should take the form of a
commission payable by DISL to DSG.
44
The conclusion that one can draw from this case is that transfer pricing issues are
never clear-cut. This case involved a lengthy and complex analysis of the contracts
and transactions involved. This case shows the importance for MNEs to re-examine
their transfer pricing policies and consider whether the most appropriate pricing
methodology has been used. It also highlights the importance of performing a sound
economic analysis by the tax authorities during transfer pricing audits.
5.5.2 Altera Corp. (the "Taxpayer") v. Commissioner (IRS) and Xilinx Inc v
Commissioner
The Altera Corp v Commissioner cases tested the arm's length principle in more
details and provided clarity regarding cost sharing regarding the development of
intangible assets.
These cases can be summarised as follow:
In a cost sharing arrangement (CSA), two related parties are generally expected to
share the costs of developing intangible property and in exchange, each party
receives the rights to make use of such property in its respective territory. The costs
to be shared would generally include compensation, such as engineers' salaries, but
whether costs also include SBC (such as non-qualified stock options, ISOs or RSUs)
has been the centre of the debate.
The Seagate vs IRS case was the first one that first highlighted this issue, it was
relating to tax years 1990, 1991 and 1992. Both the IRS and taxpayer lost cross
motions for summary judgment, as the Tax Court indicated that the issue was
inherently factual, not simply a legal issue, and a trial was therefore necessary. The
I RS conceded on the case because they had no evidence that unrelated parties share
SBC. The IRS also conceded the issue for all taxpayers for years prior to the revised
1995 Section 482 cost sharing regulations. It seems like the IRS believed the 1995
regulations provided the result it wanted, so it did not concede the issue going forward
from 1995. Over time it was then noticed that, the IRS's reliance on the 1995
regulations was misplaced. In 2005, the Tax Court in Xilinx held that, even under the
1995 regulations, participants do not need to share SBC costs because unrelated
parties would not share such costs. Xilinx presented a variety of evidence and its own
45
executives' opinions that unrelated parties do not share SBC. The IRS did not offer
any evidence that unrelated parties shared SBC on the basis that whether such
parties actually shared SBC was irrelevant because the 1995 regulations required that
"all costs" relating to the development of intangible property covered by a CSA must
be shared. The I RS had a strong view that SBC was a cost that must be shared
whether or not the cost would be shared by unrelated parties engaged in a
comparable intangible development arrangement. The taxpayer strongly countered
that the regulations commanded that the arm's length standard needed to be applied
"in every case" and, therefore, whether uncontrolled parties shared SBC in
arrangements comparable to a CSA was relevant.
The outcome of the Xilinx case essentially turned on the inconsistency in the
regulations between the "arm's length in every case" requirements versus the "all
costs" requirement. In 2010 it was noticed that the Ninth Circuit ultimately affirmed the
2005 Tax Court decision, determining that the overarching purpose of the Section 482
regulations is to put controlled parties on par with uncontrolled parties, so the IRS "all
costs" requirement must yield. Even as the Xilinx trial was under way, Treasury
proposed a new regulation expressly requiring SBC to be included in CSAs. The
proposed regulation declared that such inclusion is consistent with the arm's length
standard. During the comment period mandated by the APA, comments were
received from taxpayer groups and tax advisory firms that unrelated parties do not
actually share SBC costs in joint development agreements and similar arrangements.
According to Ryan, some commentators provided industry surveys and analyses of
SEC filings to support their point, but the Treasury regulation was finalized in 2003.
In most cases multinationals with CSAs and SBC followed the 2003 regulation -
except for Altera. It purposefully took a position contrary to the regulation and it
seems like it followed the Xilinx case developments carefully.
According to Ryan, the important things that came out from these cases are as follow:
• Although Treasury had claimed that the regulation follows the arm's length
standard, Treasury did not cite any source of information in the Preamble
supporting the regulatory conclusion that unrelated parties share SBC costs.
46
• The assertion that Treasury need not look for unrelated party transactions
similar to cost sharing because they cannot be found is illogical. Rather, it is
only after a search that one can conclude something cannot be found.
• When the IRS argued that comparable third-party transactions could not be
found because CSAs involve high-profit (i.e., crown jewel) intangibles, the Court
questioned why Treasury would lump all CSAs together - even those not
involving crown jewels.
• Treasury did not adequately respond to the mountain of comments submitted by
commentators, which provided that third parties in joint ventures and other co
development arrangements do not share SBC costs. Although Treasury's failure
to respond to an isolated comment or two would probably not be fatal to the final
rule, Treasury's failure to meaningfully respond to numerous relevant and
significant comments certainly is.
It is important for the law makers to ensure that transfer pricing laws achieve its
intended purpose. IRS amended its tax laws after the Xilinx case in order for the
fiscus to be advantageous, however they didn't consider if the amendment would
still be in line with the arm's length principle. The ruling in the Altera case is
generally regarded as a major win for the taxpayers. Given the outcome of the
Altera case, multinationals that has been following the final regulation requiring the
allocation of SBC in cost sharing arrangements, will have to consider removing
these SBC costs going forward and filing protective amended returns for prior tax
periods to preserve their ability to claim refunds (Weiss 2016).
Determination of an arm's length principle must be supported by the transaction
data between unrelated parties otherwise such cases would have far reaching
implications for the tax regulations, as it opens the gates in the future for taxpayers
to challenge the rationality of tax regulations.
47
6.1 Introduction
CHAPTERS
Discussion and conclusion
The objective of this chapter is to discuss the outcome of the research and to
provide the conclusion of the study. This chapter will summarise the findings of the
research, suggest recommendations and propose areas requiring further research.
6.2 Outcome of the research
The research focused on whether South Africa tax lawmakers have done enough to
address the challenges that BEPS brings. An analysis of Section 31 of the Income
Tax Act was done, in order to ascertain whether it was strong enough to deal with
BEPS. It was noticed that a new Section 31 introduced interesting concepts,
however it did not address all the issues addressed in OECD's action plans.
The risk and challenges imposed by BEPS were also highlighted. BEPS need to be
resolved urgently, otherwise lot of countries would run into major financial problems.
Governments find themselves in a difficult position whereby they don't know
whether to turn their states into "tax havens' or to introduce strict tax laws.
Some MNEs are introducing complex schemes which enable them to simulate
transactions, with the hope of obtaining tax benefits. It is imperative for lawmakers
to introduce laws that would be able to handle these complex schemes.
6.3 Recommendation
Given APA advantages that were highlighted in chapter 5 of this research, South
Africa will really have to consider introducing APAs. SARS is spending lot of time
and money doing Transfer pricing audit, this can be minimised through the
introduction of APA. SARS' Transfer pricing audits are usually resolved through
reaching a settlement with the taxpayers, therefore South Africa might as well
consider introducing APA. This will not only minimise the spread of BEPS, it will
also give taxpayer certainty. The stability that will be brought by APA will also make
48
it easy for foreign investors to consider investing in South Africa. It's not pleasant to
get surprise transfer pricing audits which may result in unexpected tax debt.
The Davis Tax Committee has been tasked with the responsibility of assessing
South Africa's tax policy framework, given the challenges that are brought by BEPS,
OTC will have to priorities the review of transfer pricing tax laws. The committee will
have to consider the modern business models and transactions. In chapter 5 of this
research we noticed that there are a number of action plan that South Africa still
need to address in order of South Africa's tax laws to be in line with OECD
recommendations. OTC would have to continue finding ways of ensuring that our
tax laws are able to address all the business trends. The OTC needs to be given
timelines to address the actions recommended by the OECD. Ideally South Africa
will have to ensure at the latest by the end of 2018, all the action should have been
addressed.
A survey has to be conducted by SARS to assess whether taxpayers find the
transfer pricing laws easy to understand and apply. Taxpayer will have to indicate
the ambiguous parts of the act that they struggle with understanding. Taxpayers will
find it easy to comply if clear and easy to understand, without having to make many
assumptions.
Countries like the USA and the UK have been dealing with transfer pricing for a
number of years and it would be worthwhile to engage them on how South African
transfer pricing laws can be improved. SARS need to work on improving relation
with these countries. It will also help if SARS can understand their audit
methodology and assess if will work in the South Africa's environment. South Africa
will also have to develop skills needed to address transfer pricing. SARS will have
to consider increasing its staff size and skill set to review current TP arrangements
and ensure relevant compliance.
It is also critical for South Africa to relook at the tax treaties and ensure that there
are no loopholes that could provide platform for the spread of BEPS. Some of the
tax treaties that South Africa has with other countries are very old and they are not
49
addressing the current business climate. SARS will have to go through an exercise
of assessing all the tax treaties and make sure they are still relevant. All the tax
treaties that are exposing South Africa to BEPS risks will have to be amended.
6.4 Areas requiring further research
More countries are considering lowering their taxes in order to encourage foreign
investment and reduce the spread of BEPS. A detailed study on whether this is a
move in a right direction and ascertaining the impact this would have on countries
that refuse to lower tax rates. The current president of the USA, Donald Trump, also
indicated that he is intending on cutting taxes in order to bring money back to USA,
he said "We're going to cut taxes massively. We'll cut business taxes massively.
They're going to start hiring people. We're going to bring the $2.5 trillion that's
offshore back into the country," (Samuels 2016).
A research on how a tax rate can have an impact on the tax compliance would give
governments an indication on how they should structure their tax policy. Would
Cutting Corporate Tax Rates Really Grow the Economy?
50
7. Reference List
7.1 Books
• Haupt, P., 2014, Notes On South African Income Tax, H & H
Publications, Cape Town
• Stiglingh, M. Koekemoer, AD. Van Schalkwyk L. Wilcocks JS. and De
Swardt RD., 2014, SILKE: South African Income Tax, Lexisnexis,
Durban
7. 2 Court Cases
South Africa:
• A Company & Two Others v CSARS 2014 16360/2013 ZAWCHC
33; 2014 (4) SA 549 (WCC)
• Commissioner of Customs and Excise v Randles, Brothers and
Hudson Ltd 1941 AD 369
• CSARS v Tradehold Ltd 2012 132/11 ZASCA 61
• CSARS v NWK Ltd 2010 27/10 ZASCA 168
• CSARS v NWK Ltd 2011 (2) SA (SCA)
• Zandberg v van Zyl (1910) AD 302
United Kingdom
• DSG and others v HMRC (2008} ICTA88/SCH28AA
United State of America
• Altera Corp. (the "Taxpayer') v. Commissioner (IRS) 2015 145
T.C. No. 3
• Xilinx Inc v Commissioner 2005 125 T.C. 37
51
7.3 Internet
• Beattie, G. 2014 What does aggressive tax planning mean? viewed
09 August 2016 from https://www.quora.com/What-does-aggressive
tax-plan n ing-mean
• Central Intelligent Agency n.d, The world fact book, viewed 2
February 2017, from https:ljwww.cia.gov/library/publications/the
world-factbook/rankorder/2004rank.html
• Deloitte 2016, South Africa : BEPS implementation plan, viewed on
